Broad Stock Market Outlook Remains Strong, Despite Negative Sentiment

We've discussed recently that there has been a growing amount of bearish sentiment concerning stocks. The AAII sentiment data, Pimco's Bill Gross proclaiming the "end of equities," transportation/consumer analysis and a wide variety of Fed policy naysayers are among those who fall on the bearish side of the fence.

Yet when you take a detached look at the technical picture for the broad market, the outlook remains positive for now. And when you combine relatively strong price action with negative sentiment, that often provides a recipe for further stock gains in our experience. Let the charts and technical indicators tell the tale (to paraphrase Jessie Livermore) … you might certainly have long-term opinions on inflation, the economy and gold, for example … but don't miss out on upside gains in the meantime.

Take a look at the S&P 500 Index (SPX) (SPY) daily chart below, which tracks the current price action but also includes the very steady run the market made from December 2011 to March 2012. We've placed a Fibonacci retracement on that clear price action trend, which has helped to guide some of the recent market trends.

A few things stand out here - there is a choppy and rather wide uptrend in place on the SPX since late-May, but an uptrend nonetheless (with higher highs and higher lows). Next, Daily Percent R has remained in bullish territory and the top half of its range from mid-June to the present, confirming the underlying trend strength.

In the shorter-term, we can glean some key technical levels from both the Fibonacci retracement levels and the various technical indicators on this chart (Bollinger Bands, Acceleration Bands, Exponential Moving Averages). On the upside, this trend channel is likely to run smack into the round 1400 SPX level - remember that big round numbers and strike prices are often very psychologically important to the market and can become a "self-fulfilling prophecy." We began to approach SPX 1400 recently with an intraday high of 1391. Beyond that is the key high reached in 2012 of SPX 1422 - which likely will be re-tested this year.

The question will be whether the SPX can take out 1400/1422 and make new yearly highs, or will it reverse back lower into a range. Based on previous performance analysis of the strong start to 2012 (first 6 weeks and 2 months were very strong) over the past 40 years, there is a strong likelihood that the market will hit further upside beyond 1422 in the second half of this year. Also remember that this is an election year (albeit a relatively quiet one compared to some), and the Fed and government tend to take fiscal measures to ensure the economy is improving during a presidential election year (in addition to the vast amounts of money that are spent in the campaign, which can itself juice the economy a bit).

SPX Daily Chart

(click to enlarge)

We've discussed how a variety of bearish sentiment seems to be popping up from a wide variety of sources recently. However there is one long-standing measure of the "panic level" among option traders, particularly … the CBOE Volatility Index (VIX) (VXX). This measures the implied volatility of S&P 500 Index options, and one rule of thumb on the VIX is that it represents how much the market is pricing in that the SPX could move up or down over the next 12 months on a percent basis. So a VIX in the 15 to 20 range in one way means that option traders are pricing in the SPX to move up OR down 15% to 20% over the next 12 months. On a basis going back over 30/40 years this is a fairly high reading, but in the scheme of the market volatility we've seen since the 2007 market top, it is fairly mild. And in our experience, the VIX has tended to be more of a "smart money" fear indicator in recent years … as opposed to in the 1990s and other time periods where it was often a very good contrarian sentiment indicator, especially on market pullbacks.

Take a look at the VIX Daily Chart below, the key round 20 level stands out as important this year. You can see that many times in 2012 this level has constrained VIX upside, and this has generally coincided with an upside bias to stocks. There have been some 1 day blip closes above 20, but those have quite often been reversed the next day (hence why we often prefer multiple confirms on daily charts to confirm breakouts/breakdowns, etc). Remaining below 20 provides a backdrop to further broad stock market index upside.

On the downside, 16/15/14 have marked key VIX bottoms throughout this year, but also are important VIX lows going back to 2007. So when the VIX does get down to the low end of its range, that is an area where one should be concerned about a VIX pop/stock market weakness. But keep in mind that it can remain in the low end of its range for some time as well, including weeks at a time.

Bottom line on the VIX is that the 16 to 20 (with additional downside to 15 & 14) range is kind of the normal "healthy" one currently and has been the predominant range during which we've seen stock rallies this year.

VIX Daily Chart

So when we look at the actual charts of the broad stock market (DIA) (IWM) (QQQ) and the most popular measure of option volatility, they tell a different picture than some of the negative sentiment you've been hearing recently (or in some cases, negative sentiment from perma-bears that exists for years, even decades). And there is also a historical basis to expect further market upside this calendar year based on our data testing. When positive price action meets negative sentiment, that's often a recipe for further gains.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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